Andy Rachleff is President and CEO of Wealthfront, a software-based financial advisor. Prior to Wealthfront, Rachleff co-founded and was general partner of Benchmark Capital. He also teaches courses on technology entrepreneurship at Stanford Graduate School of Business. Follow him on Twitter @arachleff.

“The defining difference between Silicon Valley companies and almost every other industry in the U.S. is the virtually universal practice among tech companies of distributing meaningful equity (usually in the form of stock options) to ordinary employees. Before companies like Fairchild and Hewlett-Packard began the practice fifty years ago, distributing stock options to anyone other than top management was virtually unheard of. But the engineering tradition that spawned Silicon Valley was much more egalitarian than traditional corporate culture.”

The equity culture among young technology companies is almost universal. When implemented properly, broad employee ownership within a company can:

Align the risk and reward of employees betting on an unproven company.

Reward long-term value creation and thinking by employees.

Encourage employees to think about the company’s holistic success.

Unfortunately, despite decades of experience building new hire option plans, many startups still fail to put in place an equity compensation plan that adequately rewards long term employees over time.

When I was a venture capitalist, I noticed companies that seldom lost employees due to recruitment had a lot in common. Sure they offered challenging and inspiring work environments sought by top-tier talent. But you might be surprised to learn they all rewarded outstanding performance through the issuance of additional stock options (or as is now the case, RSUs) in a similar way.

The Wealthfront Equity Plan

Based on my observations, I created an equity allocation plan that I encouraged all my portfolios to adopt. It worked so well that executives and my fellow board members usually brought my plan with them when they got involved with other companies. Over the years, I am proud to say that hundreds of companies, including Equinix, Juniper Networks and Opsware, adopted this plan because it just made sense.

The Wealthfront Equity Plan is designed to specifically handle the four most important cases for granting equity to employees. Each year, you create a new option pool that addresses the following needs:

New Hires: These grants are used to hire new employees at market levels.

Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire her at today for her new position.

Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.

Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities. Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.

The Key: Consistent, Early Evergreen Grants

Most companies put considerable effort into the size of their equity grants for new hires. It’s rare these days to find new hires that haven’t used a tool, like the Wealthfront Start-Up Salary & Equity Compensation Tool, to determine the appropriate amount of salary & equity to expect for a given position.

Fewer companies, especially young ones, put significant effort into thinking about follow-on grants. If you tell your employees to “think like an owner,” then you need to consistently align equity with their contribution to the success of the company.

Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.

“The average tenure for most technology employees is two to three years, and waiting until your first employees hit year four is just too late.”

Instead of an ad-hoc process, the Wealthfront Equity Plan offers a transparent, consistent and fair program of equity grants that employees can build into their long-term expectations. As a result, not only do you avoid cliffs, but you also tie both long-term tenure and contribution to their ownership stake. The best part is that, as your company grows, you always grant stock in proportion to what is fair today rather than in proportion to their original grant.

What About Dilution?

Based on our calculations, the Wealthfront Equity Plan should result in approximately 3.5% to 5% annual dilution assuming no executives need to be hired. (Please see our Slideshare presentation for the details of how to allocate stock for a 50-person private company). As a point of reference, most public technology companies increase their option pools by 4% to 5% per year, so the proposed dilution is well within the reasonable range.

The Wealthfront Equity Plan might result in 0.5% to 1% extra annual dilution relative to less generous plans. One way to think about the trade-off is to ask yourself, if you’re a stockholder, would you rather be assured of retaining a much higher percentage of your key employees and own 97% of what you would have owned without the Wealthfront plan over your four-year vesting period (4x the mid-point of 0.5% to 1%), or deal with the risk of losing valued team members and not suffer the additional dilution? I would take the extra dilution 11 times out of 10.

That being said, there are a number of board directors who think that is too much dilution for a company to absorb. A few months ago, a fellow I recruited as CEO to two of my Benchmark portfolio companies told me he never appreciated the value of the Wealthfront Equity Plan until he joined a board where the board members were too cheap to do the right thing for their employees. Needless to say, he implemented the Wealthfront Equity Plan when he started his own company.

Investors and employees make much more money by increasing the size of the pie rather than their share of the pie. The only reason not to implement the Wealthfront Equity Plan is greed, and greed seldom leads to a good outcome.

An Equity Plan that Works for Employers & Employees

One final observation about companies that successfully retain employees: They usually create a culture that treats options as something dear that aren’t offered as an alternative to a cash bonus. They encourage employees to think about increasing the value of their options through accomplishment rather than asking for more upon completion of a task. It has been my experience that companies granting options for completion of milestones seldom build a culture that values equity — and therefore suffer greater turnover.

A well-designed equity allocation plan works for both the employer and the employees. The Wealthfront Equity Plan creates a tremendous incentive for people to stay at a company without costing the employer too much. That’s the kind of win-win to which we should all aspire.

Summary: For a place that prides itself on disrupting tradition, Silicon Valley is still using a pretty traditional method for compensating startup hires and employees with stock. Here’s another idea.

Change is the only constant in life and this is especially true in Silicon Valley. We live in a time of constant change and rebirth, which we optimists think is for the better. One thing hasn’t changed: How Silicon Valley companies — especially startups — use stock to compensate and incentivize their employees.

Traditional stock options are failing to create the ownership culture we want from employees and it’s killing our ability to build companies for long-term success.

For employees, a one-year term ending on the vesting cliff date is increasingly common. This leaves a big hole in the team and the cost to hire a replacement is significant. We all want to eliminate bad matches sooner, but it’s no surprise so many employees wait for the equity. Having more non-employee equity holders causes resentment among current employees doing the hard work to create stock value. On the other side of the equation, founders and investors are increasingly tight-fisted with company ownership, allocating smaller stock pools to employees — most of which are eaten up by very early hires, rock stars or senior execs — leaving very small amounts for later hires, which does little to nurture their commitment to the company.

I’ve been involved with startups for a long time and have seen these patterns over and over. After working at a number of startups, I co-founded Equinix in 1998, Revision3 in 2005 and was the chief executive of Digg, Revision3 and SimpleGeo. I’ve also been an active advisor to several early-stage startups. After nearly twenty years of using the same recipe for employee equity, I’m taking a new approach at my new startup, Opsmatic. We are sharing equity in a new way, one we believe builds a true ownership culture that will be a key to our success.

I’ll explain more later, but in addition to a traditional stock option grant, we’re offering our first fifteen employees, or however fewer it takes to get to the next financing, an equal share of 15 percent of the company, which they will receive if they stay with the company through a liquidity event.Why do this? We are focused on attracting and retaining the best possible team over the long term. Our employees are key to our success, and we are determined to change their (and our) behavior to avoid the downsides of the traditional approach to stock allocation. As I talk to CEOs, I’ve uncovered some of the causes of these patterns.

Employee behavior

Burned by booms and busts, employees often look to maximize their compensation up front, hopping from company to company in an attempt to scale compensation or title. Most stock options have a one-year cliff; if they leave at that point, they can purchase 25 percent of their equity with no further commitment to the company, giving them the ability to diversify their equity portfolio and reduce risk.

The rise of secondary markets has complicated matters and created a pervasive myth that employees can sell their stock early. While private stock sales are available to a minority of high-value, successful companies that support these transactions, it’s not an option for most early companies. According to SecondMarket’s 2012 data, the median number of employees for companies with private stock transactions was 347 with an age of seven years and a market cap of $569.5M, and 66 percent of transactions were made by existing employees, not former employees.

Founder behavior

Founders and CEOs typically distribute equity in a long tail, most of which goes to very early employees after a first financing, leaving increasingly smaller amounts for later hires. This does not build a sense of shared ownership.

The rationale I hear is that early employees take more risk around an uncertain future, so they should get higher compensation. Lately, in conversations, I surprisingly found that people joining later often feel they are taking a larger risk around getting paid!

This may seem backward, but upon reflection, there’s always the non-trivial chance of the next round not happening or revenue not coming in before cash is burned away. A fresh, recently funded startup has more money in the bank and has made fewer execution errors, so risk is a matter of perspective.To make matters worse, I’ve talked to dozens of founders who confirmed that in retrospect, there was little correlation between the distribution of stock options and the actual value the employee brought to the company. Independent of contribution, the larger option packages are dolled out to super early employees (or co-founders) and rock stars.

A rock star hire is a hire in which founders and CEOs pay above market rates for someone they deem super-critical. Maybe you’re developing software and would benefit from someone who is famous for inventing the concept. Perhaps you need to build a new sales force, so you go after a famously successful head of sales veteran from another company. Maybe you want to recruit new talent, so you hire someone that new employees would kill to work with.

Rock stars are typically fought over, so equity distribution increases due to competition, giving these employees a larger share. Nevertheless, years later, post exit, often the unsung heroes — like employee number fifteen — weren’t benefiting in a way that reflected their contribution. As far as I’m concerned, when combined with the long-tail distribution, this is not the best way to motivate employees or engender team loyalty.

The details of our approach

To address these issues, we’ve created a new approach to equity called the Dynamic Stock Pool (DSP). This pool is designed to be a long-term incentive, encouraging loyalty and reinforcing that we will win or lose as a team. While each of our employees will get a traditional stock option grant, the majority of Opsmatic’s employee stock — 15 percent of the company — is allocated to the DSP.

The DSP pool is egalitarian, shared equally amongst the first fifteen employees we hire. So it’s a rich incentive at 1 percent of the company (before any future dilution). Typically, equity numbers of that level are reserved for VPs, CxOs and rock stars, so this is a significantly more generous offer than most early hires receive, particularly outside of management or founders.

However, here’s the catch: The stock in this pool is only distributed to employees who remain at the company through a liquidity event, such as an IPO or acquisition. If you leave before then, you don’t get any of your DSP shares — so this is truly an incentive to play for the long-term. In fact, the employees who stay through the liquidity event continue to share equally in the pool. For example, if only five of the first fifteen employees remain, each would receive 3 percent (pre-dilution).

What about…

Clearly this is different from how things have been done since companies started handing out stock options, so of course it raises a few questions.

Some feel that varying skills and experience merit differential grants. Beyond accompanying salary differences, we also have a traditional option pool to address a legitimate reason to give one employee more than another. Another challenge involves the perception of the ‘value’ of different kinds of employees. For example, some people have asked, “What if you hire a receptionist or a janitor? Should they have as much value as a developer?” Because each employee is equally diluted in the DSP, this model creates a strong incentive to only hire critical employees. This means hiring fewer non-essential personnel and prioritizing the hiring of great, mission-critical people first. If your team truly needs a receptionist to succeed, the equity is justified. As for early departures, employees who unexpectedly leave would still have their traditional vested options, and measures are in place to prevent a manager from firing someone at the end, like a game of Survivor.

There are other edge cases we have thought of and resolved, and probably complications that arise out of the longer-term nature of this incentive. However, I spent the greater part of two years working with great attorneys closing all the legal loopholes that may arise, and I’m confident enough that I’m using Opsmatic as the first test bed for the DSP.

Of course, I welcome feedback, and I’ll definitely share what I learn as we put this new approach to work.

Jay Adelson is a serial entrepreneur, having built companies such as Equinix, Digg, Revision3 and SimpleGeo. Jay founded Opsmatic in early 2013, and currently serves as Chairman and Founder.Featured photo courtesy Shutterstock user Shutterstock user AnatolyM